At the heart of any investor’s drive is to find success like Warren Buffett, or at least to find financial independence. The ultimate goal is never really in question but rather the path to get there is debated on investing forums across the world. However, there are some lessons that can be gleaned from Warren Buffett and Benjamin Graham to help an investor become more successful and be a true Intelligent Investor. Here’s a list of seven steps to take in order to become a better investor in the Buffett and Graham style.
1. Know the difference between Investing and Speculating.
One of Benjamin Graham’s greatest teachings is to avoid speculating about companies and rather to invest methodically only in situations which are sure to promise a return of capital. One easy way to think of it is that in general, an investment returns an ongoing, present income while a speculation only has a chance at returning an income in the future. In that regard, companies providing dividend payments can be classified as investments because they pay out a return of capital immediately. On the other hand, commodities such as gold are generally speculative opportunities because they only have a promise of a higher price later in the future. It is acceptable to have a small portion of a portfolio in speculative opportunities, but it is critical that the primary purpose of the portfolio remain investing. Know the difference between the two and keep the bulk of your portfolio in investments rather than speculations.
2. Understand the power of compounding dividends.
Dividends are a huge component of an Intelligent Investor’s portfolio. Over time, dividends can compound by giving a greater and greater base from which to invest. For example, assume a company’s price is $10 in year 1 and remains at that level for ten years. Investor A purchases 100 shares of the company for $1000. Each year, the company pays a 5% dividend, or $0.50 per share. If Investor A reinvests that $50 every year in the same company, at the end of ten years the investor will have an investment of 155 shares worth $1,550 even though the price of the company never changed. If the price had risen by 10% each year, which is somewhat average, the investment would be even better: $4,531.50 from 192 shares versus $2,358 if Investor A had not reinvested the dividends.
3. Stick to your established criteria and methodologies.
Once you know the criteria under which you will select investments, do not change them regularly. It may be worthwhile to hone those criteria over time, but don’t try and fit a company into your portfolio by modifying your requirements. Modifying criteria to allow a particular company into a portfolio only adds speculation to your investing because of the level of subjectivity that is involved. One of the key things that we do on ModernGraham is to utilize the same formula and requirements for every company, regardless of industry. This allows the investor to compare opportunities across industries and utilize a bottom-up approach to portfolio construction which lessens the amount of speculation.
4. Only buy companies trading at a discount to their true value.
Warren Buffett is famous for saying that “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” People often use this saying to justify paying more for a well managed company, but there seems to be an over-reliance on the company qualifiers than there are on the price qualifiers. Notice that Buffett used the terms “fair price” versus “wonderful price.” He did not say that investors should be buying wonderful companies at a poor price. As important as it is to stick to companies with strong qualitative aspects, the investor must continue to purchase only at prices that are either fair or better. To do that, you must calculate the intrinsic value of a company in order to compare the value to the market price. There’s many different theories and formulas for determining the intrinsic value, but as Benjamin Graham suggested, the formula Value = EPS x (8.5 + 2g) seems to provide a solid estimate. That’s the formula we use on ModernGraham, and you can find the calculations of intrinsic value for many companies in our Valuation Index.
5. Investigate the management and qualitative aspects of a company before investing.
This is the critical step which should rely heavily on Warren Buffett’s techniques. Benjamin Graham is a great source for determining quantitative methods for analyzing opportunities, whereas Warren Buffett has added to the analysis by providing insight into qualitative analysis. Buffett has some business tenets that help to focus the analysis, and they include:
- Is the business simple and understandable?
- Does the business have a consistent operating history?
- Does the company have favorable long-term prospects?
- Is management rational?
- Is management candid with shareholders?
Utilizing these questions in an analysis can help focus your considerations, but as stated in step 4, reaching this step in the analysis means you are already looking at a company which is trading at or below its intrinsic value. Don’t even bother considering the qualitative aspects of the management and the company if the price is way too high to be fair.
6. Remain active in learning about finance.
Be constantly reading more about finance and specifically value investing. Take the time to annually read Warren Buffett’s Letter to Shareholders. Read Benjamin Graham’s The Intelligent Investor multiple times. Doing so will help cement the concepts of Intelligent Investing in your attitude towards investing and will make you better at analyzing opportunities. It’s not necessary to avoid reading other investing viewpoints, but when you do read them try and see where other techniques fit within the classic, proven methods of Warren Buffett and Benjamin Graham. Active and constant learning are key elements of any value investor’s approach.
7. Try to ignore the market and monitor your investments infrequently.
The market will rise and fall almost as certainly as the sun and moon will rise and set except the market’s movements are not easily calculated. It is impossible to determine exactly where the market will head one day to the next, so why even bother checking on your investments so frequently? Doing so will only add to your emotions and could lead to an increase in speculation and therefore risk. If you see your investments fall on Monday and Tuesday, it is possible you will feel an urge to sell on Wednesday only to see the prices rise again on Thursday and Friday. It is far better to check the status of your investments infrequently and rebalance or make changes only when necessary. My personal approach is to feel comfortable looking at the value on any given day, but I only allow myself to make trades about once per quarter. Even then, I only trade as necessary to rebalance to my target allocations or sell if a company fails to meet my criteria. As a result, the level of emotional speculation is low.